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Retail investors who buy passive ETFs may wind up with exposure to particular stocks or markets they are not fond of because of a fund's mandate to match the index on which it’s based.KAZUHIRO NOGI/AFP/Getty Images

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Over two years, David Kletz has learned to think of some passive ETFs like chameleons because of how often they change without being noticed.

In September 2017, the Forstrong Global Asset Management Inc. portfolio manager was invested in the iShares MSCI Frontier Markets 100 Index ETF, which gave his firm exposure to markets that are still in such an early stage of development that they’re considered to be too illiquid and risky to be “emerging.” The ETF provided its holders at the time with 21 per cent and 18 per cent exposures to Kuwait and Argentina respectively.

The chameleon effect: Why investors need to understand the indices their passive ETFs trackBack to video

Only seven months later, MSCI announced that it would be removing Argentina from its frontier markets index because the country was being upgraded to its emerging markets index. Throughout the next year, the exposure would be divided among Vietnam, Nigeria, Morocco and other names that appear on the index. In June 2019, MSCI announced that Kuwait would be the next to be upgraded.

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Because the MSCI index was losing its two highest exposures, the iShares ETF — a passive one that aims to the match the index — would be forced to follow suit. Retail investors who buy passive ETFs because they don’t want to track their investments may not be aware of just how much their holdings are changing over time, Kletz said, and that’s a mistake.

“If you’re a long-term investor and you want to just buy and hold for 30 years, maybe you look past that,” Kletz said, “but if your time horizon is a bit shorter, you really need to stay on top of what’s driving the ETF and continually ask yourself: ‘Is this something I’m comfortable with owning?'”

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When the MSCI index was divesting Argentina, the exposure it formerly held in the South American country was divided into a host of riskier markets in Africa and the Middle East, Kletz said. Many of those new markets that saw their positions boosted during the rebalancing were oil-dependent, he said, meaning that the ETF’s performance became more tied to oil than he would have preferred.

Therein lies one of the weaknesses of passive investing, according to its critics. Retail investors who buy passive ETFs may wind up with exposure to particular stocks or markets they are not fond of because of a fund’s mandate to match the index on which it’s based. The experience stretches beyond them to investment firms and ETF providers, some of which admit they don’t always agree with the compositions of funds but have put those concerns aside in search of returns that match those of the greater market.

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“The default is to go as cheap or passive as possible in absence of a more tactical view,” said Kletz.

Canadians appear to feel the same way. As of June, two-thirds of ETF assets in Canada were invested in passively managed market cap index strategies, according to Horizons ETFs senior vice-president Mark Noble. Globally, that number is closer to 90 per cent, he said.

Passive strategies allow them to bet on entire markets or sectors at a time instead of trying to pick winners in each. Crucially, for investors like Kletz who are always searching for the least expensive investment vehicles, fees on passive strategies are significantly lower than those attached to active funds. Depending on where investors search for it, growth is still available when betting on an index. The strategy has proved fruitful for those who simply bought into passive funds that track the S&P 500, which has more than doubled since 2007.

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If you’re betting against an index you’re really taking a contrarian view to bet against the entire sentiment of the global stock market

Mark Noble, senior vice president, Horizons ETFs

“If you’re betting against an index you’re really taking a contrarian view to bet against the entire sentiment of the global stock market,” Noble said. “The global stock market tends to be right a lot more than the individual opinions of individual investors.”

ETF providers such as Horizons will work with indexers, asking them to create a new index to match an investment strategy that they want to introduce to the market. German indexer Solactive launched the North American Marijuana Index on behalf of Horizons so that the ETF provider could introduce the Horizons Marijuana Life Sciences Index ETF.

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Indexers can also take the initiative and create indices they think will draw attention, either as a base for ETFs and index funds, or solely for research purposes, according to FTSE Russell managing director of North American research Rolf Agather.

Based on its own ideas or the instructions of a partner, FTSE Russell will construct equity indices based on a strict set of rules — not on its own potential biases toward certain stocks. If the index is market cap based, the stocks with the highest market caps will have the highest weights. Those near the bottom of an index are in danger of falling out during a rebalance if their market caps are surpassed by another name not on the list. The same logic applies for high-yielding indices or even factor-based indices that track pools of momentum or value stocks.

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The point of rebalancing is to maintain the particular exposure outcome

Rolf Agather, managing director of North American research, FTSE Russell

Agather said rebalances generally occur between one and four times per year. Factor-based indices are often rebalanced quarterly.

“The point of rebalancing is to maintain the particular exposure outcome,” Agather said. “We don’t have any rule saying ‘This company is potentially going bankrupt so let’s take it out’.”

The rebalancing process has the potential to bring volatility to the market, Agather said, depending on the number of funds that follow it, and their size. FTSE Russell rebalances its widely popular Russell 1000 and Russell 2000 indices every June. Once the rebalancing occurs, passive funds tracking it are forced to match the alterations, leading to billions of dollars simultaneously flowing out of certain stocks that have seen their positions reduced or dropped and into those that FTSE Russell is increasing exposure to.

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“That is the single biggest trading day in the U.S.,” Agather said.

Some critics will argue that during rebalancing periods, certain stocks that have a presence in multiple ETFs have the potential of being dragged down without merit because of the movement of ETF flows. Noble calls that a “red herring,” saying that action is only possible when an ETF owns 10 to 20 per cent of an issuance.

Noble is steadfast on the benefits of passive investing, but, like Kletz, admits he doesn’t always agree with the composition of certain indices. He remembers feeling uncertain when the North America Marijuana Index added Tilray Inc. when it was trading at all-time highs, because of the impact that would have on the Horizons Marijuana Life Sciences Index ETF. Tilray would then go on to lose 92 per cent of its value in little more than a year.

“From a fundamental perspective, that doesn’t feel good as portfolio manager, but we have an investment objective and obligation to replicate that index,” Noble said. “That’s the discipline of being a passive investor — you’ve given up that discretionary view on stocks.”

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